MIT Sloan School of Management News Briefs — July 2005

New research headed up by an MIT Sloan professor finds that corporate management systematically conceals bad news from investors as long as possible.

The findings carry lessons for new leadership at the Securities and Exchange Commission. “Our evidence suggests that, over the past decade, firms' corporate governance systems and public regulations and enforcement aimed at eliciting full disclosure and other bad news from managers are not quite working,” says MIT Sloan Professor S.P. Kothari, coauthor of a study analyzing whether managers suppress unfavorable information. “I thought that the labor market as well as litigation and other actions by the SEC and prosecutors would collectively discourage managers from hiding the bad news. I was surprised that managers are still so successful at it.”

Kothari and his coauthors, MIT Sloan Professor Peter Wysocki and Boston College Professor Susan Shu, compared how the stock market reacts differently to good news and bad news announcements by companies. The researchers found that, on average, the magnitude of the market's reaction to bad news exceeded that for good news, even after allowing for the scale of the news itself. This difference suggests that investors are “surprised” by public bad news announcements whereas good news appears to be leaked by management before formal public announcements. Kothari and his coauthors argue that managers' personal career concerns, including compensation and promotion, motivate them to delay the release of bad news to investors.

So, even as the SEC and other regulators continue to enforce regulations, Kothari says company boards and CEOs must be more accountable and willing to make sure that their managers disclose bad news in a timely and direct way. “It becomes a governance issue,” said Kothari. “In some ways, directors ought to be thinking more about how they can get their managers to cough up bad news and get it known rather than sit on it, which in many cases can make matters worse.”

This governance problem continues despite recent high-profile corporate scandals and prosecutions, according to Kothari. “Too many boards continue to be like country clubs. There is sometimes even greater separation between the board and management. Corporate structure still tends to be hierarchical.”

CEOs must also be willing to press their managers to disclose bad news as soon and completely as possible, Kothari said. “CEOs are smart people, but after they become CEO, too often no one challenges them. Their brains are not being tested so their logical reasoning is not sharpened. Over time, they lose their edge, unless the board itself challenges the CEO.”